Posted 10-01-2015 4:25 pm by
Whether you are buying or selling a business, one of the issues that will need to be agreed upon by the buyer and seller when the business is under contract is the purchase price allocation. To put it simply, how is the total purchase price going to be allocated towards various categories for tax purposes?
Suppose a business is being sold for $1 million. For tax purposes, the total purchase price of $1 million needs to be allocated amongst various categories such as equipment, goodwill, non-compete agreement, etc. Once the allocation is mutually agreed upon, both the buyer and seller will need to report the same allocation to the IRS on their tax returns. If the buyer and seller do not report the same allocation for the sale, it is most likely a trigger to the IRS for an audit. In other words, how the purchase price is allocated has tax implications for the buyer and seller. Understanding the implications will allow each party to negotiate better and propose a purchase price allocation that is workable for all parties.
The first step to allocating the purchase price is understanding whether the business sale is structured as an asset sale or a stock sale. Suppose the business being sold is Wonderful Balloon, Inc. If the sale is structured as an asset sale, the buyers will set up their own entity to acquire the assets of Wonderful Balloon, Inc. For an example, the buyers might set up Adventure Partners, LLC to buy the equipment, vehicles, and assets of Wonderful Balloon, Inc. After the sale, the seller may choose to shut down Wonderful Balloon, Inc. because it is for the most part an empty corporation. On the other hand, if the business sale were structured as a stock sale, the buyers are actually buying the stocks of Wonderful Balloon, Inc. After the sale, the buyers will become the new shareholders of Wonderful Balloon, Inc. and continue to operate the business using Wonderful Balloon, Inc.
The reason it is important to understand whether the business sale is an asset sale or stock sale is that the categories for the purchase price allocation are a bit different. For stock sales, the entire purchase price may be allocated to the value of the stock. The seller pays the capital gains rate for stocks held more than one year, and the buyer does not get a write off and must accept assets at the current book value. Occasionally, the parties may agree to allocate a portion of the purchase price to the non-compete agreement and/or the training/consulting agreement. For the portion allocated to the non-compete agreement, it is ordinary income to the seller and the buyer gets to amortize it over 15 years. For the portion allocated to the training/consulting agreement, it is ordinary income to the seller and the buyer gets to expense it out as paid.
In the case of asset sales, common purchase price allocation categories include equipment, non-compete agreement, and goodwill. Trade fixtures, furniture, and equipment are considered tangible personal property. For the portion allocated to equipment, any gains in excess of the book value will be treated as ordinary income to the seller unless the seller has held it for longer than one year (in which case it becomes long-term capital gains), and the buyer gets to depreciate it per IRS schedules. Depending on the jurisdiction of the business being sold, the buyer may need to pay tax at closing to the local and State agencies on the portion of the purchase price allocated to equipment. For instance, in King County, WA, the buyers will need to pay 6.5% State use tax and another 3% local use tax at closing for the portion of the purchase price allocated to equipment. In many cases, the buyer prefers to keep the equipment portion low in order to minimize the amount of cash the buyer has to come up with at closing. On the other hand, some lenders may require a good amount of the purchase price allocated to equipment in order to fund the loan. The portion of the purchase price allocated to the non-compete agreement is treated as ordinary income to the seller, and buyer gets to amortize it over 15 years. For the value placed on goodwill, it is treated as long-term capital gains to the seller if held for more than one year, and the buyer gets to amortize it over 15 years.
When it comes to purchase price allocations, the key is to work with professionals who understand the intricacies of how the proposed allocation impacts each party. When the buyer’s CPA and seller’s CPA are both involved, an experienced business broker can facilitate the negotiations process to ensure that a mutually satisfactory outcome is achieved for both the buyer and seller.
Aaron Muller is a business broker in Washington State who has sold over 120 companies and facilitated over 40 SBA loans for his clients. Contact Aaron at (425) 766-3940 to inquire about buying or selling a business.